There are new business models coming up in venture capital. This new wave is made up of Revenue-Based Investors. They utilize creative investing structures, over the traditional equity VC.
Revenue-Based Investing, also known as RBI VCs are gaining a lot of momentum and will reach the point where they are a major segment of the venture ecosystem. This will end up displacing some traditional equity Venture Capital, but it also means that it will have a much bigger impact on the expansion of the pool of capital that will be available for all new age and budding entrepreneurs.
What Is Revenue-Based Investing?
Revenue-based financing, also known as revenue-based investing or royalty-based financing, is a means where companies can raise capital for their business by using different investors. These investors, in return, will receive a percentage of the organisation’s current gross revenues.
When companies use the revenue-based financing investment option, they give their investors a regular share of their businesses income. This is done till a previously fixed amount gets paid, which is usually a multiple of the principal investment made. It usually ranges between three to five times the original amount that has been invested.
It seems like a viable and an attractive way to raise capital for companies. This way, companies can raise the capital they need successfully without having to sacrifice a part of their equity or using any of their assets as collateral. Also, when you compare Revenue-Based Investing to debt and equity financing, revenue-based investigation turns out to be a much easier process, and it also needs less documentation.
What are the Characteristics Revenue-Based Investing?
The typical characteristics of Revenue Based Investing are:
- The principal amount gets completely funded at closing
- RBI is always structured as a loan
- The payments made each month to the investors equal a set percentage of the company’s monthly revenue usually 1 to 9%)
- The monthly payments go on till the predetermined amount gets paid back, which is typically 1.3-2.5 times the amount of the investment (this multiple is known as the “cap”)
- When the RBI hits maturity, which takes about 3 to 5 years, there is no unpaid amount of the cap which is due
The existing RBI structures were created to help protect the equity of both the founders of the business as well as the investors. It will soon become part of the standard options that are available to founders for raising capital, and they can be put to use whenever deemed appropriate.
Difference between Revenue-based Investing and Debt and Equity-based Financing
Revenue-based investing may sound very similar to debt financing. This is because in both cases, the investors involved are entitled to regular repayments of the capital they have invested. But there are no interests involved when it comes to revenue-based funding, the founders instead pay the investors back in multiples of the principal amount. This means the investors gain their returns which are higher than their initial investment. Also, when it comes to revenue-based financing, companies have no obligation to provide collateral to their investors.
Equity-based investment models require their founders to transfer the ownership, even partly, to all the investors, something which isn’t the case for Revenue-Based Investing. Often equity warrants to get issued to investors. Companies do not have to give their investors seats on the board of directors either.
Major Revenue-Based Investors
The biggest revenue based investors in today’s financing world have been listed below:
- Alternative Capital comes with a special program for companies who are in the pre-seed stage and need product development.
- Bigfoot Capital provides RBI, term loans, and lines of credit to all selected SaaS businesses, but mainly for small and medium sized businesses. As of now, they evaluate about 20 companies a month and issue term sheets to 25% out of those, depending on who fits their investment criteria
- Corl approves funding in a short span of time and fund up to ten times the company’s monthly revenue. All applications are approved much more quickly than the industry average and most businesses that they invest in are E-commerce, SaaS, among other digital businesses.
- Decathlon Capital has become the largest revenue-based financing investor in USA. They devote 50% of all their investments to non-tech businesses.
- Earnest Capital cannot technically be considered Revenue-Based Investing because they invest via a Shared Earnings Agreement. It is a newer investment model which is created with the community so it is transparent. It was designed to align the investors with the founders of companies.
- Feenix Venture Partners has developed a unique investment model. It combines investment capital with payment processing services. The companies they invest in receive their investment in debt or equity and the company then utilizes a subsidiary of Feenix Venture Partners as its credit card payment processor.
- Fledge helps entrepreneurs to create impactful companies and at scale. Fledge does this by giving the companies in their portfolio intense, short programs that are filled with education, guidance, and a lot of mentorship.
- Flexible Capital Fund invests in the form of near equity capital, which is through subordinated debt and royalty financing, to the growth-stage companies in Vermont. The companies are typically a part of one of these industries – sustainable agriculture and food systems, forest products, and clean technology sectors. They are the only licensed lenders in Vermont who can provide royalty financing. Flexible Capital Fund also acts as an advisory and helps with the development resources required which will assist their portfolio companies’ growth.
Advantages and Disadvantages of Revenue-Based Investing
When it comes to the founders of companies, the main advantages they get from Revenue-Based Investing are:
- The founders have greater control over their company, especially when compared to other VC models because RBI investors usually don’t take board seats.
- There is very little to almost no dilution in the company because RBI investors generally don’t take equity
- RBI-backed founders always want to maintain control, ownership and optionality in their company. They want to keep the two main options open for them – whether or not to raise VC later and/or to be able to sell their business at their convenience if they want to
- Predictable and flexible payments for founders going with the RBI method of raising capital. Payback gets calculated as a percentage from the revenue for the investors. This means the founders do not have the risk of cash crunches that can take place when companies need to pay off loans in large amounts.
- Investors are also highly motivated in helping the company grow. This is because the faster the company grows, the quicker they get their revenue back. This way both the company and the investors have aligned incentives for the company’s success. Most companies want to make a profit as quickly as possible, and it becomes less risky and it becomes more convincing for the RBI investor to make the investment.
- Revenue-Based Investing works best for non-tech companies. It gives non-technology based businesses the attention and opportunities that they deserve to grow their capital, something which they do not get from institutional venture equity investors.
- Revenue-Based Investing also works really well when it comes to early-stage companies. RBI investors are usually more comfortable when compared to traditional financiers in terms of providing capital to companies who are just starting out and might not even have generated any meaningful revenue or profit.
- There are a lot of tax benefits to Revenue-Based Investing. Companies can deduct interest payments when they structure their RBI funding package well. This has a positive impact on the company’s after-tax cost of capital, which is something that a company has to pay for their RBI capital.
- Revenue-Based Investing was created to replace equity as a solution for companies to raise capital. RBI investments are usually structured in a way that they go on for three to five years. This is shorter than the typical lifespan of an equity VC fund, but much more than regular debt. This way companies receive an infusion of capital which helps them grow.
- It is very easy to terminate the relationship between the founder and the investor if it’s not working. Both investors and founders can make a mistake when selecting their investors or companies to invest in. In case the partnership does not work out, RBI is essentially debt and not equity, so the founders can pay the sum off to end their relationship.
- The cost of capital for companies is tax deductible, something which is not true when it comes to traditional equity VC.
- Traditional lenders usually require some form of personal guarantee and this is something founders do not have to worry about if they go with Revenue-Based Investing.
The disadvantages the founder faces if he chooses to raise capital using Revenue-Based Investing are:
- Companies need to have revenues or clean access to revenues in their near future for the investors.
- There is always a built-in cap when it comes to the amount of capital which companies can raise every transaction. Revenue-Based Investors will usually not give capital that will equal to more than 3 or 4 months’ worth of MRR.
- Founders need to make punctual and regular monthly payments to their investors, which means they need to manage their cash and income extremely carefully.
- Revenue-Based Investing comes with a shorter term alignment with the company’s investors. This is because the investors’ financial stake is not equity, which means that RBI investors could get less motivated to support a company long-term.
- If companies choose Revenue-Based Investing to raise capital, it may make it more difficult for them to raise traditional equity VC in later stages because traditional VCs might just see RBI investors in the cap table as a negative. They are negative because the RBI investors are taking money out of the company prior to the VC seeing any return on its investment. This portion could have been reinvested by the VC for the growth of the company.
- RBI capital is generally treated as a debt to the company.
- Sometimes, Revenue-Based Investors may need personal guarantees.
- A hands-off approach may actually act as a hindrance and not benefit the company. A lot of people start companies because they want to be their own boss and have complete freedom to build their vision, but often having somebody to keep you in check can be very valuable in mentoring the founders, providing them with honest feedback, and so on. This support is lacking when it comes to RBI investors.
- If the company is nothing more than a small startup, it can get difficult to receive this type of funding in the beginning because they might lack the requirements that RBI investors pose, either based on revenues generated, customer base or gross margins.
- Regulation might be the biggest issue for founders when it comes to Revenue-Based Investing. RBI is a relatively new funding option, which means a lot of banks haven’t started doing it yet.
How to Decide on a Financing Option for Companies to Raise Capital
There are a lot of different available options when it comes to raising capital for companies. Some may require companies to promise some definite amount of equity in the business. Some financing options may ask for a personal guarantee so the founders can be held personally responsible for paying the debt if the business fails.
It is not easy to get a business loan for a lot of companies when they are just starting out because the business has not yet managed to establish a solid financial history. Each available funding option has its own list of pros and cons, so founders need to carefully weigh their options before selecting the means to raise capital for their company.
The biggest attraction about Revenue-Based Investing for a lot of small business owners is the flexibility they get when it comes to making payments and at the same time, there is no need for the company to give up equity in exchange. RBI can get more expensive in the long run for companies, but it is a much simpler method of generating capital for companies. Founders do not have to deal with extensive credit checks and loan approval
The first step before deciding on a financing option for companies is to check their finances to see if they can afford a particular type of loan. The funding option founders choose will affect their business because gaining capital is a vital component of running a business.
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